Derivative Securities- Learning Objectives

1. Derivative Securities- Learning Objectives • What is a derivative security? • Important characteristics of a derivative security; • Markets for derivative securities; • Terminology is used to describe derivative transactions; • How are prices for derivative securities quoted?

2. Derivative Securities- Learning Objectives • Similarities and differences between forward and futures contracts; • Put and Call option contracts; • How are forward contracts, put options, and call options related to one another?

3. Forward and Futures Contracts - Learning Objectives • Hedge ratio and how it is calculated? • What economic functions do the forward and futures markets serve? • Futures pricing; • Agricultural futures and financial futures; • Stock Index futures; • Currency futures

4. Derivative Instruments • Value is depends directly on, or is derived from, the value of another security or commodity, called the underlying asset • Forward and Futures contracts are agreements between two parties - the buyer agrees to purchase an asset from the seller at a specific date at a price agreed to now • Options offer the buyer the right without obligation to buy or sell at a fixed price up to or on a specific date

5. Why Do Derivatives Exist? • Assets are traded in the cash or spot market • It is sometimes advantageous enter into a transaction now with the exchange of asset and payment at a future time • Risk shifting • Price formation • Investment cost reduction

6. Derivative Instruments • Forward contracts are the right and full obligation to conduct a transaction involving another security or commodity - the underlying asset - at a predetermined date (maturity date) and at a predetermined price (contract price) • This is a trade agreement • Futures contracts are similar, but subject to a daily settling-up process

7. Forward Contracts • Buyer is long, seller is short • Contracts are OTC, have negotiable terms, and are not liquid • Subject to credit risk or default risk • No payments until expiration • Agreement may be illiquid

8. Futures Contracts • Standardized terms • Central market (futures exchange) • More liquidity • Less liquidity risk - initial margin • Settlement price - daily “marking to market”

9. Options • The Language and Structure of Options Markets • An option contract gives the holder the right-but not the obligation-to conduct a transaction involving an underlying security or commodity at a predetermined future date and at a predetermined price

10. Options • Buyer has the long position in the contract • Seller (writer) has the short position in the contract • Buyer and seller are counterpartiesin the transaction

11. Options • Option Contract Terms • The exercise price is the price the call buyer will pay to-or the put buyer will receive from-the option seller if the option is exercised • Option Valuation Basics • Intrinsic value represents the value that the buyer could extract from the option if he or she she exercised it immediately • The time premium component is simply the difference between the whole option premium and the intrinsic component • Option Trading Markets-options trade both in over-the-counter markets and on exchanges

12. Options • Option to buy is a call option • Option to sell is a put option • Option premium - paid for the option • Exercise price or strike price - price agreed for purchase or sale • Expiration date • European options • American options

13. Options • At the money: • stock price equals exercise price • In-the-money • option has intrinsic value • Out-of-the-money • option has no intrinsic value

14. Investing With Derivative Securities • Call option • requires up front payment • allows but does not require future settlement payment • Forward contract • does not require front-end payment • requires future settlement payment

15. Options Pricing Relationships Factor Call Option Put Option Stock price + - Exercise price - + Time to expiration + + Interest rate + - Volatility of underlying + + stock price

16. Profits to Buyer of Call Option Profit from Strategy 3,000 Exercise Price = $70 Option Price = $6.125 2,500 2,000 1,500 1,000 500 0 (500) Stock Price at Expiration (1,000) 40 50 60 70 80 90 100

17. Profits to Seller of Call Option Profit from Strategy 1,000 Exercise Price = $70 Option Price = $6.125 500 0 (500) (1,000) (1,500) (2,000) (2,500) Stock Price at Expiration (3,000) 40 50 60 70 80 90 100

18. Profits to Buyer of Put Option Profit from Strategy 3,000 2,500 2,000 Exercise Price = $70 Option Price = $2.25 1,500 1,000 500 0 Stock Price at Expiration (500) (1,000) 40 50 60 70 80 90 100

19. Profits to Seller of Put Option Profit from Strategy 1,000 500 0 Exercise Price = $70 Option Price = $2.25 (500) (1,000) (1,500) (2,000) (2,500) Stock Price at Expiration (3,000) 40 50 60 70 80 90 100

20. Creating Synthetic Securities Using Put-Call Parity • Risk-free portfolio could be created using three risky securities: • stock, • a put option, • and a call option • With Treasury-bill as the fourth security, any one of the four may be replaced with combinations of the other three

21. Put-Call-Forward Parity • Instead of buying stock, take a long position in a forward contract to buy stock • Supplement this transaction by purchasing a put option and selling a call option, each with the same exercise price and expiration date • This reduces the net initial investment compared to purchasing the stock in the spot market

22. An Overview of Forward and Futures Trading • Forward contracts are negotiated directly between two parties in the OTC markets. • Individually designed to meet specific needs • Subject to default risk • Futures contracts are bought through brokers on an exchange • No direct interaction between the two parties • Exchange clearinghouse oversees delivery and settles daily gains and losses • Customers post initial margin account

23. Hedging With Forwards and Futures • Create a position that will offset the price risk of another holding • holding a short forward position against the long position in the commodity is a short hedge • a long hedge supplements a short commodity holding with a long forward position

24. Hedging With Forwards and Futures • Relationship between spot and forward price movements • basis is spot price minus the forward price for a contract maturing at date T: BtT = St - Ft,T • forward price converges to the spot price as the contract expires • hedging exposure is correlation between future changes in the spot and forward contract prices and can be perfectly correlated with customized contracts

25. Hedging With Forwards and Futures • Calculating the Optimal Hedge Ratio • net profit from the position

26. Forward and futures contracts are not securities but, rather, trade agreements that enable both buyers and sellers of an underlying commodity or security to lock in the eventual price of their transaction Forward and Futures Contracts:Basic Valuation Concepts

27. Valuing Forwards and Futures • Valuing forwards • Valuing futures • contracts are marked to market daily • * = the possibility that forward and futures prices for the same commodity at the same point in time might be different

28. The Relationship Between Spot and Forward Prices • If you buy a commodity now for cash and store it until you deliver it, the price you want under a forward contract would have to cover: • the cost of buying it now • the cost of storing it until the contract matures • the cost of financing the initial purchase

29. The Relationship Between Spot and Forward Prices • These are the cost of carry necessary to move the asset to the future delivery date

30. Financial Forwards and Futures: Applications and Strategies • Originally, forward and futures markets were organized largely around trading agricultural commodities • Recent developments in this area have involved the use of financial securities as the asset underlying the contract

31. Financial Forwards and Futures: Applications and Strategies • Interest rate forwards and futures were among the first derivatives to specify a financial security as the underlying asset • forward rate agreements • interest rate swaps

32. Financial Forwards and Futures: Applications and Strategies • Long-term interest rate futures • Treasury bond and note contract mechanics • CBT $100,000 face value • T-bond >15 year maturity • T-note 10 year - bond with 6.5 to 10 year maturity • T-note 5 year - bond with 4.25 - 5.25 years • Delivery any day during month of delivery

33. Financial Forwards and Futures: Applications and Strategies • Long-term interest rate futures • Last trading day 7 days prior to the end of the month • Quoted in 32nds • Yield quoted is for reference • Treasury bonds pay semiannual interest • Conversion factors for differences in deliverable bonds

34. Short-Term Interest Rate Futures • Eurodollar and Treasury bill contract mechanics • Creating a synthetic fixed-rate funding with a Eurodollar strip • Creating a TED spread

35. Stock Index Futures • Intended to provide a hedge against movements in an underlying financial asset • Hedging an individual stock with an index isolates the unsystematic portion of that security’s risk • Stock index arbitrage • prominent in program trading

36. Currency Forwards and Futures • Currency quotations • Direct (American) quote in U.S. dollars • Indirect (European) quote in non U.S. currency • Reciprocals of each other • Interest rate parity and covered interest arbitrage